What is a CFD and What is CFD Trading?


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Want to know more about what is a CFD & CFD Trading?

Contracts for Difference, or CFDs as they are commonly known, is a derivative product which derives its price from the underlying stock, index, FX pair or commodity it is tracking.

For example, if you are looking to trade National Australia Bank (ASX:NAB) and the current ASX stock price was $30 then the CFD would also be $30.

what is a CFDChart courtesy of Metastock

The CFD on NAB will attempt to mirror the performance of the underlying stock at all times.

Contracts for difference are similar to trading normal stocks except you need a small amount of money up front.

There are some other subtle differences like CFD finance & CFD leverage and anyone looking to trade this product should certainly consider the CFD risks involved.

Are CFDs suitable for beginners?

You may be asking whether you should be trading CFDs if you are a beginner.

The key to any financial product is to make sure you have a thorough understanding of what is involved.

So you must know what is a CFD, what are the risk associated and what benefits may CFDs have if I were to start trading them.

With a thorough understand of what CFD trading is about, you can then decide if the product is for you.

Click play on the video below to find out more.

So who owns the CFD or stock?

When trading Contracts for Difference you don’t actually own the physical stock and you don’t get a contract note as you would with normal share trading.

You are simply trading the difference in price between where you got in and where you got out.

Why do people trade contracts for difference (CFDs)?

There are 6 main reasons why people trade Contracts for Difference (CFDs).

  1. Take advantage of short-term price swings or movements in the stock, index or commodity markets.
  2. You get to trade using the leverage CFDs offer. In some cases, you can trade at 100 to 1 leverage or even higher with Forex, Index and Commodity products.
  3. To hedge an existing share portfolio. Some people use CFDs as a risk management tool instead of a speculation opportunity.
  4. You can access international stock markets through the one trading account.
  5. Often, traders can take advantage of lower commission rates or brokerage. Some Australian CFD brokers charge as little as $5 for an Aussie Share CFD trade.
  6. You are able to take advantage of short selling. This means you can benefit by opening a short trade if the position falls in value. Conversely, if your short trade rises, then you will likely be in a losing situation.

What are the differences of CFD trading to stock trading?

In fact, CFD trading and stock trading are very similar but there are 3 main differences.

Here are the main differences between trading stocks versus trading CFDs.

  1. You only put up a fraction of the total position as margin (from 1-95%)
  2. Commission rates are often lower (starting at $5 or 0.07%)
  3. You can profit when the market is falling by short selling CFDs

The main reasons share traders move into CFD trading is the ability to access more opportunity.

With a $20,000 share trading account, you can literally only trade up to $20,000 in total value.

But what if you have a trading system that has an edge (ie it works) and your main limitation is a lack of funds?

In this case, it may be worthwhile applying your trading system to CFDs and access more funds through leverage.

Applying CFD leverage to a share trading system

Let’s say you have a trading system that delivers 10% return per year with a 4% drawdown historically. This means on average, over your tested period of time, it makes 10% on your money but at some stage has the ability to drawdown up to 4%. A fair system.

What if you were to apply this same system but use 2 times leverage.

This means your $20,000 account can now access opportunity up to $40,000.

In theory, your original system is basically doubled, meaning you can potentially make 20% return on your $20,000. But do keep in mind, your risk has now doubled.

Doubling your drawdown with leverage – Is this the knife’s edge?

If your system stayed true to the tested historical results, your drawdown will also double to 8%.

Of course, this is just a hypothetical situation, but you can start to see why people make the transition to trading CFDs. Especially once they get their head around what is a CFD.

As you headline above asks ‘is this the knife’s edge?’. Well, no. Fortunately or unfortunately, many traders use much higher levels of leverage and multiply their historical drawdown.

Well, no. Fortunately or unfortunately, many traders use much higher levels of leverage and multiply their historical drawdown.

Fortunately or unfortunately, many traders use much higher levels of leverage and multiply their historical drawdown.

When you dramatically increase the amount of CFD leverage you use, you start to trade dangerously.

Click play on the video below to run through the main reasons share traders make the move to trading CFDs.

What are the differences of CFD trading to options trading?

The reason CFDs have grown in popularity so quickly is that they are very easy to understand. This is the single biggest benefit that CFD trading has over options trading. Options trading can be quite difficult to learn initially and many traders give up as a result.

The other benefits of CFD trading versus options trading are:

  • No time expiry;
  • No time decay;
  • You don’t have to choose a strike price;
  • When trading Direct Market Access (DMA) CFDs you are not competing against a professional market maker;
  • When trading Direct Market Access (DMA) CFDs the spread is exactly the same as the real market. Option spreads can get out to 7-10%; and
  • You don’t need to understand the ‘Greeks’ when CFD trading

Who can trade CFDs?

CFDs are generally available to anyone over the age of 18 years of age.

Please keep in mind that when trading a leveraged product like CFDs the risks can be more than what you initially start with so CFD trading is not for everyone.

Please understand the CFD risks and read the relevant PDS and disclaimer of each company.

Having said that, CFDs can be traded by…

  • Investors looking to hedge their existing share portfolio
  • Short term, medium term or long term traders
  • Intraday traders
  • Swing traders
  • Pretty much anyone looking to take advantage of a price movement, either long or short.

What are the risks of CFD trading?

Contracts for Difference or CFDs are a leveraged product which means you can access say $50,000 worth of stock even if you only have $5,000 in the account.

Even more, if you trading indices, commodities or Forex. You can get up to 400 to 1 leverage with some Australian Forex brokers.

CFD leverage is a double edged sword which means it’s great when you are winning and not so great when you are losing.

The greatest risk CFDs pose is the fact you can lose more money than what you start with.

Here are some of the other risks involved with CFD trading.

  • You can lose more money than what you have in your account
  • Short selling leaves you exposed to unlimited risk
  • CFDs tend to lend themselves to shorter time frame trading which is considered the toughest form of trading around
  • Current advertising seems to suggest that quick riches are easy with CFDs but this is not the case because
  • CFDs increase the size of your wins but also increase the size of your losses

What are the available methods to trade CFDs?

There are two main methods of accessing or trading CFDs which are:

  • Direct Market Access (DMA) or
  • the Market Maker model

There is no right way or best way as each has its own advantages and disadvantages. You are best off asking around and talking to other CFD traders to see what they prefer and their reasons for selecting one or the other.

It is very common for professional CFD traders to use both Direct Market Access (DMA) and Market Maker models together.

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